foreign exchange risk management in the canadian department of

MILITARY ECONOMICS
THE HIDDEN COST OF OPERATIONS:
FOREIGN EXCHANGE RISK
MANAGEMENT IN THE CANADIAN
DEPARTMENT OF NATIONAL DEFENCE
by Naceur Essaddam, Christopher H. Bucar and Richard A. Groves
T
he Canadian Department of National Defence
(DND) is a public institution charged with
defending Canada, defending North America
and contributing to international security. It
is because of these latter tasks that DND is
required to undertake activities outside of Canada, and, in so
doing, incur financial risk in the form of exposure to foreign
currency exchange rate fluctuations. Furthermore, given
Canada’s relatively small defence industrial base, the
Department also sustains foreign exchange risk in the
acquisition of the equipment and supplies needed to conduct
military and security operations. As a consequence, the
failure to mitigate this risk results in DND incurring hidden
costs in the execution of the Defence Services Program
(DSP) 1 and this compromises the stewardship of scarce
defence resources.
In recent years, DND has recognized that risk
management is an essential component of effective
decision-making and good management practices. 2 It
was even proposed by the Chief of Review Services in
2000 that, in the field of risk management, DND needs to
examine those risks that it is not ‘world class’ at managing,
and then assess the economics of transferring such risks
to those better able to manage them. In particular, according
to Bodnar et al, the transference of financial risk is common
practice in multinational corporations (MNCs) through the
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Canadian Military Journal
use of various financial and non-financial hedging
techniques. Notwithstanding that current Government of
Canada financial regulations permit the use of financial
derivatives, 3 and despite the widespread adoption of
hedging by the private sector, there has been limited
application of proven financial hedging techniques by the
Government of Canada.
Similarly, the use of hedging techniques has also
been adopted by institutions within other governments.
Among the first to adopt this financial risk perspective has
been the United Kingdom’s Ministry of Defence, 4 and
the New Zealand Defence Forces, 5 who implemented a
foreign currency exposure risk management policy using
foreign currency hedging practices. Even though these
governments have implemented private sector hedging
practices, within the Canadian public sector and DND there
is a common misconception that hedging is tantamount to
speculation. As a result, risk management has emphasized
event and technical risk (i.e., environmental, health and
Doctor Naceur Essaddam is an Assistant Professor in the Department
of Business Administration at the Royal Military College of Canada.
Major Christopher Bucar is the Deputy Base Commander of Canadian
Forces Base Petawawa. Major Richard Groves is the Acting Material
Group Comptroller 5 at National Defence Headquarters in Ottawa.
61
DND photo Ka2004-R102-073a
b y C o r p o r a l C h r i s C o n n o l l y, O p A t h e n a R o t o 1
The first 18 of 60 Mercedes-Benz G-Wagons at Kabul’s airport in March
2004. Part of the Light Utility Vehicle Wheeled acquisition, the total project
cost is $C 306 million, and it represents greater than 90 percent exposure
to the Euro.
safety issues) surrounding the conduct of military operations
or the acquisition of equipment, and it has not considered
the risk associated with foreign currency fluctuations.
Consequently, the interpretation of financial risk within the
Department has been relatively limited, concentrating on
accounting and budgetary transactional issues. Therefore, the
objectives of this article are to introduce the concept of
foreign exchange risk management, to present a new
framework for the management of foreign exchange risk,
and to propose an implementation strategy for the
Department of National Defence .
In Section I we will develop further the motivation
for hedging within DND. Section II will describe the
existing DND budget process in order to explore the potential
to apply proven financial hedging techniques to the
management of foreign exchange risk. In Section III, we
will outline a hypothetical financial hedging strategy
for reducing the risk associated with foreign currency
fluctuations, and Section IV will consist of our findings
and recommendations.
I–
T
The Motivation for Hedging
currency expenditures. By increasing the certainty of cash
flows, hedging supports budgetary planning and capital
allocation decisions through the continuous management of
forecasted transactions. Hedging foreign currency exposure
would be beneficial to DND, considering Canada’s relatively
small defence industrial base that requires DND to source
much of its materiel and service needs from outside Canada.
As a consequence, the Department is exposed to a sizeable
foreign exchange risk in the acquisition of the equipment and
the supplies and services needed to conduct military and
security operations. Since 1994, the magnitude of DND’s
foreign exchange exposure has increased – due to sustained
periods of extensive overseas operations, and increased
levels of foreign procurement. Specifically, for the period
April 1994 to October 2002, DND incurred foreign
currency exposure of $6.5B Canadian dollars on $101.2B
in expenditures, representing an average of 6.4 percent
annually in support of the Defence Services Program (DSP).
The existence of economies of scale is another reason to
consider foreign currency hedging, considering DND’s
foreign currency exposure is of sufficient magnitude to take
advantage of the benefits of financial hedging instruments.
For example, DND’s foreign currency exposure over the
period 1994 to 20017 went from $519M to $1.19B, which
would be sufficient to generate the economies of scale
necessary to maximize the benefit of financial hedging.8
In addition to the magnitude, the timing of the exposure
is another critical aspect of financial hedging. Fully 89 percent9 of DND’s annual foreign expenditures – which include
capital acquisition expenditures, grants and contributions
made to foreign agencies and alliance obligations, and the
cost of foreign operations – are known with a lesser degree of
uncertainty in terms of magnitude and timing.
Before presenting the new framework for foreign
currency risk management, it is necessary to understand how
foreign currency exposure is considered during the DND
budgetary process.
II – The Existing DND Budget Process and
Foreign Exchange Exposure
T
o better understand the utility and application
he hedging of foreign exchange risk refers to techniques
of financial hedging to mitigate the effects of
undertaken by a firm in order to mitigate the impact of
foreign exchange risk, it is first necessary to explore
adverse exchange rate fluctuations on the value of the firm.
the current DND budgeting and expenditure processes
More specifically, private sector firms use financial hedging
in relation to foreign currency rate
as protection against unexpected exchange
fluctuations. The budget planning
rate movements in order to minimize the
“In recent years,
process commences in March-June
impact of foreign exchange rate fluctuations
DND has recognized
of the preceding year, and, using
on future cash flows. This, in turn, reduces
the
forecasted
foreign
exchange
cash flow uncertainties, improves financial
that risk management
rates prepared by the DND Director
decision-making, and facilitates cash
is an essential
Budget (DB) for selected foreign
conservation and planning for capital
6
component of effective
currencies, anticipated foreign currency
needs. Similar to the private sector, many
budgetary requirements are converted
of these benefits could equally accrue
decision making and
into Canadian dollars. Adjustments
to DND. In this regard, the paramount
good management
to budget amounts are possible up
rationale for financial hedging is that it can
practices.”
until government approval, and then,
reduce the adverse impact of foreign
during the fiscal year, budgets may
exchange rate volatility on DND’s foreign
62
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A
s noted by Lewent and Kearney, and also Brown
at References, a prerequisite for implementing a
foreign exchange risk management strategy requires
that firms have the ability to generate exchange rate forecasts
that can be used to develop a hedging strategy, and to
select the most appropriate financial instruments to fulfill
that strategy. The Department does not use its forecasted
foreign currency exchange rates as a benchmark for
evaluating a foreign exchange risk management program.
Rather, it is used only for budgetary planning purposes.
Consequently, DND must maintain contingency reserves
as a measure to mitigate foreign currency fluctuations.
w w w. r a y t h e o n . c o m
From this budgetary cycle, foreign exchange exposure
manifests itself in two forms. The first is in the variance
between exchange rates applied at the time of budgeting,
compared to the rates when the obligations are liquidated.
These differences are generally absorbed in the local budgets
being used to procure the goods or services. The second
form relates to the variance in exchange rates applied at
the time obligations are liquidated and the exchange rate
applied by counter parties. A corporate gain or loss
on exchange account is used to capture the differences in
the liquidated and counter party rates when a payment
instrument is used for a foreign currency obligation.
MILITARY ECONOMICS
be
adjusted
through
supplemental
We have demonstrated that the
“From this budgetary
estimates. Managers are expected to
motivation to hedge exists in DND and
use this internal forecasted rate to assess
have shown how the Department currently
cycle, foreign exchange
the impact of foreign currency fluctuations
handles foreign exchange exposure within
exposure manifests
on their plans and operations when
its current budgetary process. The next
itself in two forms.”
determining initial budget allocations and
section will discuss a new framework
conducting budget reviews. By so doing,
for foreign exchange risk management.
managers are able to develop contingency
reserves to mitigate the effects of adverse currency
III – New Framework for Foreign Exchange Risk
movements, and, if required, to request additional funds.
Management
The Improved Point Defence Missile (Evolved Sea Sparrow Missile), which will be fitted to the Halifax Class Frigates. The total project cost is $C513
million, and it represents greater than 95 percent exposure to the US dollar.
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63
For example, capital acquisition projects,
which are often susceptible to currency
fluctuations, are mandated to maintain
a contingency reserve ranging from
5-to-15 percent of the project’s
estimated cost as a risk mitigation
measure.10 These funds represent opportunity costs to the department, as they are
not available for more productive or
essential activities. In effect, foreign
exchange exposure is ultimately passed
through to the Canadian taxpayer, or it is
simply absorbed within the Department
and results in a diminished defence
capability, thereby further exacerbating
an already tenuous situation of declining
real defence purchasing power.
The nature of the DND foreign exchange exposure
comes from the fact that we must pay much of our
foreign obligations in a foreign currency. To do this,
we essentially convert the foreign currency expenditures
into Canadian dollars at the time the obligation is
liquidated, and, in so doing, subject ourselves to
currency fluctuations. One financial instrument to
reduce this fluctuation is the forward contract.
A forward contract is a private contract negotiated
in the present that gives the contract holder both
the right and full legal obligation to conduct
transactions at a specific future time involving
a specific quantity and type of asset at a predetermined
price. For example, DND could agree today
to purchase a certain amount of a foreign currency
with a financial institution for delivery on a specific
future date at a specific exchange rate. The contract
may be customized for almost any amount and
maturity date, and does not require a capital
outlay. Generally, private firms enter into contracts
to eliminate the impact of any unfavourable exchange rate
changes. The forward contract is the simplest
hedging instrument, and it is the most commonly used
one in the private sector.
Our proposed framework for hedging foreign
currency risk uses forward currency contracts for several
reasons. First, the forward currency market represents
the world’s largest foreign exchange derivatives market,
thereby contributing to the instrument’s liquidity.
Second, these instruments provide conventional maturities,
i.e., 30, 60, 90, 180 day and one year,11 that better match
the DND budgeting and expenditure cycle. Third,
these instruments do not require the upfront payment
of a premium or the maintenance of a margin
account, thereby precluding the need for substantial
cash outlays. Finally, the use of forward contracts
would also have the effect of eliminating the
differences
between
the
budgeted
and
actual
expenditure, thus offering a greater degree of
stability in the planning, budgeting and liquidating
of foreign currency obligations by isolating the effect
of foreign exchange exposures.
64
DND could effectively use forward
contracts to reduce its exposure to currency
fluctuations involving probable anticipated,
but not tightly committed, transactions,
and those transactions with firm foreign
currency commitments. To do so would
require the implementation of a framework
that first identifies, then assesses controls
and monitors the risk. A key component
of this framework would be a policy
describing the Department’s foreign
exchange risk mitigation strategy that
articulates the risk tolerance levels
for foreign currency fluctuations, and
prescribes a hedging strategy for
mitigating those risks deemed outside
the tolerance levels. The hedging strategy would specify
the limits on the types, notional value as a percent of
exposure, and the timing of forward contract (or other
derivative instruments) positions, as well as the exact
procedures to be followed by all individuals involved with
hedging foreign exchange transactions. The policy would
also outline the separate responsibilities for executing
hedging transactions, and for accounting and control
activities. Senior management oversight would be provided
in the form of a multidisciplinary financial risk management
committee (FRMC) comprised of senior departmental
comptrollers. This committee would meet to review hedging
strategy performance, prepare quarterly reports to senior
management, and would be accountable directly to the most
senior levels of the department, the Program Management
Board (PMB).
“Senior management
oversight would be
provided in the form
of a multidisciplinary
financial risk
management
committee (FRMC)
comprised of senior
departmental
comptrollers.”
The actual execution of the hedging strategy could
be done by a small group of experienced individuals
organized into a financial risk management unit (FRMU) and
responsible for accomplishing the hedging strategy approved
by the FRMC. The FRMU would be responsible for
determining currency forecasts, as well as the overall value at
risk to the Department as a result of foreign currency
exposure. The group’s activities would also include liaising
with the Bank of Canada’s (BoC) Risk Management Unit,
as well as the Receiver General of Canada (RG) and
Public Works and Government Services Canada (PWGSC)
to ensure the seamless execution of hedging transactions.
As depicted in Figure 1, the practice of implementing a
hedge would centre around the determination of a currency
forecast, often referred to as the internal hedge rate, as the
basis for internal planning and evaluation. This indicator
would then be used by resource managers to prepare a
forecast of anticipated foreign currency expenditures/
revenues by activity/program, which would, in turn, be
identified in the annual business plans. From these business
plans, the FMRU would then organize the forecasts by month
for the various foreign currency exposures. Based on the
forecasted exposure and other macro-economic factors, a
hedging strategy (i.e., timing, duration, percentage, currency,
and so on) would be devised and submitted to the FRMC for
approval. When a particular hedging strategy is approved,
the FRMU would execute the trades in conjunction with
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FRMU/DB
Update
Business Plan
Senior Managers
MILITARY ECONOMICS
Prepare Internal Hedge Rate
Determine exposure
FRMU/DB
Prepare Hedge Strategy
Accept/Reject
Strategy
FRMC/PMB
Execute Trades
FRMU
Confirm and Record Trades
Accounting
Update Exposure File
FRMU/DB
Update
Internal Hedge Rate
Figure 1
a financial institution. In reality, this process would be
quite dynamic and would require continual oversight and
monitoring to ensure adherence to financial regulations and
to see that the practice of hedging does not inadvertently
increase DND’s foreign currency exposure. It should be
noted that a key benefit of this process would be greatly
improved senior management visibility into the Department’s
monthly cash flows and would result in more informed
financial decision-making.
IV – Conclusion
T
when applied within the context of selective hedging
strategies on the DND budget.12
Implementing the practice of hedging to reduce the risk
associated with foreign currency exposure could be
accomplished under the auspices of the Government of
Canada’s Management Accountability Framework and
Modern Comptrollership 13 modernization initiatives,
and could thereby contribute to the DND’s culture of
management and leadership excellence. Similarly, other
Canadian Government departments, as well as other nations,
could benefit from the application of a private sector foreign
exchange risk management framework.
his article has examined the financial risk associated
with DND’s foreign exchange exposure and has
The authors gratefully acknowledge the financial
proposed implementing the practice of foreign currency
support provided by the Department of National Defence.
hedging by using forward contracts to mitigate the risks
We also acknowledge the assistance
associated with foreign currency exposure.
provided by the staff of the Directorate
We then suggested a financial risk
“There are
of
Managerial
Accounting
and
management framework that describes how
Comptrollership, the Material Group
the practice of hedging might look if it
some interesting
Comptroller and the Director Budget
were implemented in DND, to include
possibilities for future
Strategic Finance and Economic Analysis
the high-level structure and procedures.
research with
within the Canadian Department of
There are some interesting possibilities for
National Defence Headquarters as well
future research within DND and the wider
in DND and the
as the Office of the Treasurer of the
Canadian public sector. For example, it
wider Canadian
New Zealand Defence Forces.
would be worthwhile to apply and quantify
public sector.”
the impact of using forward contracts and
other financial derivatives, such as options,
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65
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NOTES
1.
2.
3.
4.
5.
66
The DSP represents all the activities that the DND
is mandated to deliver.
According to the Treasury Board (2003) the
principle of integrated risk management is a key
component of both Modern Comptrollership and
the Management Accountability Framework.
Canada, Financial Administration Act, 2003.
The United Kingdom Ministry of Defence
enters into forward contracts annually with
the Bank of England to cover the majority
of its foreign exchange requirements for the
upcoming year. (UK MOD, Annual Report and
Accounts 2002/2003).
The New Zealand Defence Forces uses forward
currency contracts as part of its normal operations.
It enters into foreign currency contracts to hedge
6.
7.
8.
9.
short-term foreign currency transactions. (New
Zealand, Departmental Forecast Report for the
year ending 30 June 2004).
For elaboration, see Lewent and Kearney, Froot
et al., Bodnar et al., Joseph, Allayannis and
Ofek, and Brown at References.
Source: DND Accounting System.
For elaboration, see Main and Géczy et al. at
References
Sixty-six percent of the total foreign expenditures
are derived from the capital acquisition and
national procurement budgets, another 12 percent
is associated with grants and contributions made
to foreign agencies and alliance obligations, while
11 percent is related to the cost of operating in
foreign locations.
10.
11.
12.
13.
Defence Management System, Chapter 9 Part 2,
Contingency Cost Allowance, 2002.
Forward contracts greater than one year were
excluded as the accuracy of the exposure forecast
deteriorates and the risk of the exposure not
materializing increases (Brown, 2001).
See Morley and Simpson at References for
amplification.
Modern comptrollership is a shift from a
primarily financial focus to a broader perspective
involving the sound management of all resources
through informed, effective decision-making.
This new focus is to be achieved by shifting
the managerial emphasis from controls and
compliance to results and values. (Canada,
Treasury Board, 2001).
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